We use cookies to customise content for your subscription and for analytics.If you continue to browse Lexology, we will assume that you are happy to receive all our cookies. For further information please read our Cookie Policy.

Mutual fund servicers must make California tax return decision now

A mutual fund service provider has a choice on its 2007 California franchise tax return: Use “market” sourcing to compute its California sales factor—following a controversial new regulation; or use “cost of performance” sourcing—following the statutory rule. Out-of-statebased mutual fund service providers that follow the new approach may see their tax liability balloon.

The problem stems from a controversial new regulation that takes effect starting with the 2007 tax year. Under that regulation, receipts earned by a mutual fund service provider must be sourced for sales factor purposes utilizing a “market state approach.” This new approach was not the result of any legislative change. Rather, it was the result of administrative fiat. Indeed, the statutory authority for sourcing a mutual fund’s sales factor is still the “cost of performance” approach under California’s version of UDITPA section 17. The new regulation is purportedly authorized by California’s version of UDITPA section 18—which is supposed to be limited to unique situations involving “distortion.”

Many believe this “new” regulatory approach (see explanation below) has no basis in law and is directly contrary to the manner in which the FTB has taxed mutual funds for 40 years. Thus, the options for mutual funds are:

Follow the new regulation and voluntarily pay more California franchise tax than arguably required by law.

Follow the new regulation but file a refund claim with the FTB.

Do not follow the new regulation. Instead, follow the statute and await an audit and a proposed assessment.

A taxpayer taking option #2 or #3 should expect to confront the FTB on this issue. In our view, a taxpayer that chooses to confront the FTB will likely have strong reasons to do so. We have represented, and will continue to represent, mutual funds that oppose the FTB on this regulatory change in direction.

For instance, in the regulatory approval process, Reed Smith lawyers pointed out to FTB staff that there were serious legal problems with the abrupt change in the manner in which it has taxed mutual funds since 1967. The legal problems included, but were not limited to, the fact that FTB staff had not met its legal burden to prove the need for changing from the standard apportionment formula sales factor that it has applied to mutual funds for more than 40 years. In truth, FTB staff offered no substantial evidence whatsoever to justify the abrupt change.

These points fell on bureaucratic deaf ears. The FTB adopted the regulation anyway. This action appears to be in direct contravention of recent California Supreme Court authority establishing that it is the FTB’s burden to justify by clear and convincing evidence any variance it seeks from the standard UDITPA section 17 sales factor.

We continue to support out-of-state based mutual funds that are impacted by this regulation, and we would be happy to discuss which procedural option is most appropriate for your company’s particular situation. We can also discuss with you the FIN 48 aspects of this situation.